The No-Growth Rally

By David Waddell

Over 200 S&P 500 companies have now reported earnings. While 70 percent or so have beaten expectations, the blended earnings growth rate has basically flat lined. Using revenues as a purer gauge adds little encouragement. Revenues have also flat lined over the last year. Without an uptick in global economic activity or the ability to pass on price increases to customers, US earnings look winded. How can the rally persist without growth?

The price level of the S&P 500 equals total earnings multiplied by valuation. At year-end 2011, the S&P 500 traded for 13.04 times trailing operating earnings. At year-end 2012, the S&P 500 traded for 14.73 times. Currently, the S&P 500 trades at 16 times earnings. In other words, since 2011, the multiple of the market has expanded by 24 percent while the price of the market has advanced 26 percent...meaning the entire advance since the end of 2011 has been due to multiple expansion, not earnings growth. Why are multiples expanding?

First, tail risks (Euro collapse, Chinese recession) have abated, making investors more confident. Second, loose monetary policy globally has driven “safe asset” returns on government bonds to zero. With inflation nearing 2 percent, purchasing an asset yielding anything less is a money loser. For the past few years, investors have cautiously migrated back into equities, wringing driving up valuations for riskier and riskier asset classes as they venture out of government bonds. They passed through commodities, gold, corporate bonds, preferred shares, master limited partnerships, real estate investment trusts, high yield bonds and dividend paying stocks. For instance, humdrum utility stocks now trade for 19 times trailing earnings versus 16 times for the S&P. Why? Utilities yield 4 percent while 10 year Treasuries yield 2 percent. In fact, each of the sectors in the S&P 500 that yield more than the 10 year Treasury trade at valuations above their 20 year averages.

If you invert the 16 P/E on the S&P 500, you can compare the “earnings yield” to the yield on 10 year bonds. Currently, the earnings yield is 6.25 percent. This compares to 10 year Treasuries at 1.7 percent or corporates at 2.7 percent. As long as these rates remain anchored and earnings remain neutral, the valuation of the market can drift higher attempting to close the gap. If bond yields stayed the same and the gap closed tomorrow, S&P valuations could mathematically rise to 50. More likely, yields will rise along with valuations vectoring in on a mid-point.

To summarize, corporate earnings growth for large cap companies has now synchronized with nominal global GDP growth. The investment thesis for investing further in large cap US stocks hinges on acceleration in global economic growth and/or continued quantitative easing by global central banks to anchor fixed income yields securing the valuation advantage for equities. While we remain optimistic about the Fed’s vigilance and therefore the continued case for multiple expansion, we would much rather see return contribution come from revenue and earnings growth.

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.